I work as a portfolio manager for a global macro hedge fund in San Francisco, specializing in fixed income and foreign exchange in developed economies. I seek to understand the interaction between the economy and financial markets, especially by analyzing the fundamental economic data underlying the behavior of markets and policymakers. My previous experience in fixed income includes quantitative work in credit derivative. I hold graduate degrees in statistics and finance from the University of Chicago and the Universite Catholique de Louvain in Belgium.

More Punch, Less Bowl: Fed To Keep Rates Low For Long Time To Come

Newly-minted Federal Reserve Chair Janet Yellen has been hovering around the punch bowl of late. Since the 2008 financial crisis, a zero interest-rate policy and quantitative easing have stimulated modest economic growth. Now nearly six years in, as the economy picks up a touch, the world watches, speculating when Yellen will surprise the party by taking the punch bowl away. Will it be in six months? A year?

Everyone enjoying the festivities shouldn’t fret. A sober look at the facts of our economy strongly implies that we should expect no interest rate hikes from the central bank long into the future. Party on.

As we move through the second quarter of the year, forecasters have begun issuing expectations that the U.S. economy will start gaining speed after a sluggish winter. Conventional market wisdom anticipates the economic recovery to build greater momentum over the year, pushing the Federal Reserve to take action and raise rates. But ever since the Great Recession hit rock bottom we’ve seen similar bursts of optimism and each time the Fed has failed to deliver any change in interest rate policy.

The smart investor should ask whether this time the punchbowl policy is any different. As the Fed has a dual mandate to promote strong employment and provide price stability, it will be a long, long time before it can raise rates to achieve its mandate.

Interest rate hawks point to recent declines in unemployment as a strong signal of economic recovery. But they fail to appreciate that over the last year these declines have been largely due to demographic realities as aging baby boomers leave the workforce altogether. As the economy continues to heal, laid-off workers will reenter the labor pool, offsetting future baby boomer retirees, and the workforce participation rate will remain roughly flat over the coming years. Population growth requires the economy to add about 100,000 new jobs per month just to break even, which will continue to create headwinds against a potential unemployment rate drop.

With inflation measures well below targets, the Fed’s price stability mandate is far from being threatened. This is not surprising for two reasons. One is the persistent output gap. The other is because the three largest foreign economies have become massive deflation exporters—China, by way of monetary tightening; Japan, by the effect of its monetary policy on its exchange rate; and Europe, via its competitive adjustment. None of these will change any time soon, and should keep a lid on any price pressures within the U.S.

Beyond the strict Fed mandate, the broader economic landscape shows several signs that point towards no rate hikes from the Fed. While it is true that the economy has improved, this recovery has been notable for its muted credit creation alongside very low growth in capital expenditures, as companies have chosen to hoard cash rather than circulate it by making investments. Such hoarding dampens economic activity both in the medium term and the long term, as smaller and fewer investments today lead to depressed prospects for future productivity gains in the years ahead. With no innovations, real economic growth will stagnate.

The fragility of the economic recovery became evident in one of the past year’s biggest growth catalysts: the housing market. Since last spring, this sector has provided some solid gains to the overall economy. But last summer’s rising mortgage rates—due in part to expectations that the Fed would end its Treasuries buying spree—have essentially stopped housing sector improvements, resulting in little growth in that part of the economy over the past six months. The housing recovery has now matured, as banks have raised their credit standards and fewer new homeowners are able to get mortgages, so we won’t see the same pace of growth as we did leading up to the Great Recession.

Even this scenario assumes we will see continued, albeit anemic, growth. But a wider historical perspective suggests that economic expansions last five years on average, and next year will mark the sixth year since the recession. If we accept simple statistics and history, we cannot rule out another recession, which would delay any rate hike for several more years.

When considering all of these facts together, it is highly unlikely that the Fed will act to raise rates any time soon. While it may be tempting to scrutinize every word Yellen utters for the slightest signs that the punchbowl might be taken away, a savvy investment strategy knows that, given economic realities, interest rate hikes are a long way off. Expect more punch, less bowl.

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